Imagine that your bank decided they would pay you negative interest.
That means that, instead of earning regular interest for depositing your funds with the bank, you pay your bank interest to keep your money in your account.
It sounds crazy, doesn’t it? Yet, several of Europe’s central banks have cut key interest rates below zero and kept them there for more than a year. And as of January, Japan is trying out negative interest rates too.
WHY HAVE NEGATIVE INTEREST RATES ARRIVED?
For the most part, some central banks have introduced negative interest rates in a bid to reinvigorate their economies – beyond what they’ve been able to achieve to date with more traditional stimulatory efforts.
According to The Economist, in June 2014 the European Central Bank (ECB) began paying -0.1% on deposits held in its vault, before lowering the rate to -0.2% in September. Denmark and Switzerland have negative rates, as well. On 12 February 2015, the Swedes followed suit: the Riksbank cut its benchmark interest rate to -0.1%. And on 16 February 2016, Japan joined the party, with the Bank of Japan (BOJ) announcing that it will charge an interest rate of -0.1% for excess reserves parked at the bank by financial institutions.
So why have negative interest rates become the policy choice du jour? There are three key reasons.
These central banks are hoping to make it unattractive for individuals and businesses to hoard money, and seeking to encourage them to spend more.
Second, they want to lower the costs of lending, making it attractive for consumers and business to borrow and spend which would help stimulate the economy.
And finally, it could help depreciate their domestic currency. Negative rates might send investors in search of better returns abroad, leading to capital flowing out of the country. That would make imported goods more expensive, helping to combat deflation and giving a growth-enhancing boost to exporters.
That’s all very well, you might say. But why would anyone want to pay a bank to look after their money? Why not just put the money under the mattress?
Well, first, it’s not very practical, or indeed safe, to store large amounts of cash at home.
Second, some people are more concerned about the return of their capital (that is, capital preservation) over the return they earn on their capital (like interest) that they are willing to pay banks to look after their money.
NEGATIVE BOND YIELDS
As well as overnight rates set by central banks and affecting retail deposits, yields on government bonds in a few countries have recently been below zero, in some cases even for 10-year bonds, as in Switzerland and Japan.
Negative yields reflect both supply and demand factors, as well as the low inflation environment. On the supply side, central banks in Europe and Japan are still carrying out a policy called ‘quantitative easing’. This means that along with keeping overnight lending rates below zero, they are buying government bonds in a bid to flood the system with money and generate a self-sustaining economic recovery.
On the demand side, these negative bond yields might reflect a high degree of risk aversion among some investors. As discussed above, this is because people are more concerned about preserving the value of their capital than on achieving growth.
In terms of the economic environment, expectations that inflation will remain very low lessens one of the key risks for bond investors – which is that rising prices erode the purchasing power of the bond’s future cash flows.
DO BONDS STILL MAKE SENSE?
For global fixed income investors, negative interest rates and bond yields below zero may make you wonder if bonds still make sense.
We believe that they do.
First, interest rates and yield curves (the trajectory drawn by bonds of the same credit quality but different maturities) are not the same in every country. For example, policy rates in the USA, the UK, Canada, Australia, New Zealand and Norway are still positive.
Rates vary because economic conditions, demand and supply factors vary across countries. The US, for instance, began raising rates from near zero late last year amid evidence of strengthening activity. Australian cash rates are around 2%, among the highest in the world.
Second these overseas bond returns may not be negative once they are hedged back to local currencies using local interest rates. With Australian cash rates at 2% and New Zealand’s at 2.5%, that becomes the floor for investment in global bond markets.
Hedging provides the diversification benefits of different yield curves without the currency risks.
Third, what matters to investors is not so much the absolute level of yields, but how they change. Yields and price are inversely related, so when yields (the interest rate paid) fall, prices rise. That means that even if yields are negative, they could still fall further and provide a positive capital return.
Fourth, the shape of a yield curve is more important than the absolute level of yields. For an example, an individual curve can still be upwardly sloping even if it is below zero. In this case, shorter-term yields are below longer-term. That gives you the option of taking more term risk and getting the benefit when yields fall (prices rise).
Finally, regardless of the interest rate cycle, bonds still play a diversification role in a portfolio composed of multiple asset classes in equities, property, cash and bonds. This is because they behave differently to those other assets.
In summary, while interest rates and bond yields have turned negative in some economies as central banks attempt to stimulate activity, this doesn’t take away the important role fixed interest can play in a diversified portfolio.
The benefits of taking a global approach to fixed interest, varying term exposure according to the range of opportunities available and hedging out currency risk remain as strong as ever.
As to the broader implications of negative interest rates for investment markets, we are still in the very early days of this policy initiative, and so there simply hasn’t been sufficient time to draw any clear conclusions.
In the meantime, we suggest you keep investing and don’t rush to put your money under the mattress.
With thanks to “Mattress Money” (Dimensional Fund Advisors March 2016), “Why negative interest rates have arrived—and why they won’t save the global economy” (The Economist, 18 February 2015) and “Negative Interest Rates” (Bloomberg View, 18 March 2016).